Having
taken years to draft and agree,
Dodd-Frank and the European Market Infrastructure
Regulation (EMIR) are now beginning to come into
force.

David Field, executive director at Rule
Financial

Research conducted by Rule Financial in 2012 revealed huge
disparity in the level of preparedness for regulatory reforms
between buy-side and sell-side firms. One year on, little
progress has been made in closing this gap.

While the
European Securities and Markets Authority has announced a
six-week delay in the introduction of mandatory reporting for
over-the-counter (OTC) derivatives, extending the deadline to
February, there are still a number of pressing matters for the
buy side to consider. These include:

The
scale of reform: firms must ensure that regulatory governance
is regularly reviewed and that adequate programmes are in
place to manage any operational change that is
required;

New trade-reporting responsibilities: it cannot be
assumed that sell-side firms will perform trade reporting,
and buy-side firms must keep sight of the fact they are still
legally responsible for trade reporting, even if they have
delegated the function;

Understanding the changes that are required to address
collateral segregation: the rules vary between Dodd-Frank and
EMIR regulation;

Effects on operating models: some buy-side firms are
revisiting their operating model for the processing of
OTC derivatives in light of the imposition of business
conduct rules under the Dodd-Frank and EMIR regulation;

Efficient connectivity: with deadlines fast approaching,
some buy-side firms have yet to understand and implement the
required connectivity solutions for new OTC services 
affirmation, trade reporting, etc  all of which require
proper planning, implementation and testing.

Under both
sets of regulations, a buy-side institution has an obligation
to submit or to verify the trade details given to the trade
repository. This will require a control framework which can
grow as data-sets fragment further, in an environment where the
organization has to reconcile submissions at multiple trade
repositories.

There are
other differing requirements under
Dodd-Frank and EMIR. The latter requires a wider range of
trade details to be reported, some of which might not be
available through common trade execution standards, meaning
that institutions must find a way to enrich or modify any
reporting message sent to a trade repository on their
behalf.

As this
must be completed within a specified timeline, institutions
must assess the need for any infrastructure build and
investment.

Tackling the
collateral challenge

A
cornerstone of regulatory reform on both sides of the Atlantic
is the creation of central counterparties (CCPs) and the
mandatory clearing of eligible products, designed to mitigate
counterparty risk. While central clearing reduces counterparty
credit risk, initial and variation margin  often cash
 will have to be posted at the CCP.

For the buy
side, high-grade collateral might come at a cost. This is
either through the increased cost of eligible collateral or the
lost opportunities arising from depositing funds with the CCP.
In the short-term, CCP requirements might drive margin
requirements higher than bilateral agreements, and shift to
daily and intraday calculations.

Post
reform, it is estimated that more than two-thirds of current
bilateral trade volume will be cleared through CCPs. This will
lead to a bifurcated market that might be daunting to some
buy-side participants, increasing their operational processing
and risk.

As part of
this process, institutions can gain support from triparty
structures, using independent collateral agents and systems
that efficiently underpin collateral reallocation and intraday
substitutions based on collateral values.

Triparty
agents reduce operational risk and complexity, help manage
counterparty exposure and provide clients with a wide array of
solutions to transform and optimize collateral. However,
choosing the right clearing agent can be
challenging.

Going for
brokers

The CCP
mechanism, its financial strength and the selection of a
clearing broker/s  it is desirable to have an alternative
in the event of broker default  are crucial decisions for
the buy side. If there is no direct relationship with the CCP,
then the clearing broker assumes the credit risk and acts as
the intermediary.

Buy-side
firms must familiarize themselves with the options available to
them, as the collateral taker (the CCP) sets the parameters for
the collateral it will accept from the collateral provider (the
buy-side firm).

Clearing
brokers should also be reviewed for suitability and stability,
as not only will they hold the firms initial margin but
they will also help clear the firms trade in the years
ahead. It is imperative there is no repeat of instances where
client funds come under risk  as happened with MF
Global.

Due to the
increased costs of margining, there is also the likelihood that
risky, long-dated and bespoke swaps will become uneconomical.
This might drive participants towards using more vanilla
products. Indeed, it could potentially lead buy-side firms to
use the futures market to mimic their swaps trades, given its
lower margin costs and less stringent regulatory
requirements.

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